Aberforth Smaller Companies

Aberforth Smaller Companies Trust plc
Audited Annual Results for the year to 31 December 2023

The following is an extract from the Company's Annual Report and Financial Statements for the year to 31 December 2023. The Annual Report is expected to be posted to shareholders by 8 February 2024.  Members of the public may obtain copies from Aberforth Partners LLP, 14 Melville Street, Edinburgh EH3 7NS or from its website: www.aberforth.co.uk. A copy will also shortly be available for inspection at the National Storage Mechanism at: https://data.fca.org.uk/#/nsm/nationalstoragemechanism.

FINANCIAL HIGHLIGHTS

Total ordinary dividends (excluding special dividend) for the year of 41.50p per share represents growth of 6.4% compared to last year’s 39.00p per share. In addition, a special dividend of 9.00p (last year: 8.30p) results in total dividends of 50.50p per share for the year.

INVESTMENT OBJECTIVE

The investment objective of Aberforth Smaller Companies Trust plc ("the Company" or "ASCoT") is to achieve a net asset value total return (with dividends reinvested) greater than that of the Numis Smaller Companies Index (excluding Investment Companies) (“NSCI (XIC)” or “benchmark”) over the long term.

From 1 January 2024, the benchmark was renamed the Deutsche Numis Smaller Companies Index (excluding Investment Companies).

CHAIRMAN’S STATEMENT TO SHAREHOLDERS

Review of performance

ASCoT’s net asset value total return in the twelve months to 31 December 2023 was +8.2%. The discount of ASCoT’s share price to its net asset value widened very slightly over the year. Therefore, ASCoT’s share price total return was +8.0%. The total return from the Numis Smaller Companies Index (excluding investment companies) (NSCI (XIC)) was +10.1%. Larger UK companies, represented by the FTSE All-Share, were up by 7.9% in total return terms.

It was a volatile year for financial markets as they wrestled with inflation and its implications for monetary policy. A positive outturn for 2023 seemed unlikely as late as November. But then favourable inflation data in both the UK and the US encouraged the view that the next move in interest rates would be downwards. This triggered a powerful and welcome rally into the year end. In the UK, this has so far been led by the mid cap stocks, to which ASCoT has a relatively low exposure.

The financial markets maintained an obsessive focus on the interest rate cycle, largely overlooking other developments in 2023. With the war in Ukraine continuing, Hamas’s October attacks intensified geopolitical risk. Meanwhile, the economic backdrop also deteriorated as the impetus of the pandemic recovery faded and the impact of earlier monetary tightening affected activity. Through the second half of the year, evidence built of more challenging trading conditions both in the UK’s domestic economy and in many overseas markets. The frequency of weaker trading updates rose and many companies, not just in the UK, experienced a year of lower profits in 2023.

Another notable feature of 2023 was the persistent despondency about the UK equity market and its constituent companies. Institutional and retail investors continue to move money out of the UK and valuations for most UK companies are very low, particularly among smaller companies. Low need not mean attractive, but the Managers’ report makes a strong case for why the prevailing doom and gloom have been overdone.

Dividends

My statement twelve months ago described the very strong recovery in dividends paid by investee companies following the pandemic. This recovery took ASCoT’s Revenue Return per Ordinary Share to its highest ever level of 55.64p. Remarkably, this number was exceeded in 2023, with Revenue per Ordinary Share reaching 59.79p. Seven special dividends were helpful, but even with these excluded from both years, the underlying rate of growth was 9%.

The strength of this income performance means that the Board can meet its ambition to grow ASCoT’s full year ordinary dividend above the rate of inflation, which was 4.0% in December. In dividing Revenue per Ordinary Share between the ordinary dividend, the special dividend and the addition to revenue reserves, we have taken into account the economic outlook for 2024 and the Managers’ dividend estimates for the investee companies. These estimates point to a year of lower dividend receipts, which would be consistent with what does appear to be a more difficult trading environment for companies. However, it seems likely that Revenue per Ordinary Share will still be well above its pre-pandemic levels.

The Board therefore proposes a final dividend of 28.55p per Ordinary Share, which would represent growth of 5.9% on the previous year’s 26.95p. Together with the interim dividend of 12.95p, the full year dividend would be 41.50p. The year-on-year increase of 6.4% would be well above the rate of inflation. We also propose a special dividend of 9.00p, which underlines how robust a year it was and ensures that ASCoT passes the HMRC’s minimum retention test for investment trusts. The total dividend in respect of 2023 of 50.50p would allow 9.29p to be added to revenue reserves to take them to 80.1p per Ordinary Share, which would cover the ordinary full year dividend just under two times.

In what has been the best year for income in ASCoT’s 33 years, the Board considered it appropriate to add to revenue reserves. Prudent management of revenue reserves since 1990 has made an important contribution to ASCoT’s dividend record, allowing it to be sustained even in the more challenging years. Thus, amid the pandemic in 2020, ASCoT was able to grow its dividend by 4% when the UK equity market saw dividends decline by 33%. Revenue reserves also allow the Managers to appraise investments in the context of total returns – they are not limited to finding value among higher yielding companies. This flexibility has been important as ASCoT has navigated its way through previous economic cycles.

Gearing

In May 2023, ASCoT announced the refinancing of its credit facility with The Royal Bank of Scotland International Limited. The term of this £130m facility runs to June 2026 and is designed to align with the three yearly continuation vote.

The Board’s gearing policy has been consistent throughout ASCoT’s life: gearing is deployed tactically with the aim of taking advantage of periods of stress in equity markets. ASCoT has been geared on four occasions in its 33 years. The most recent of these came in 2020 amid the pandemic. Gearing has remained in place since then and has added to ASCoT’s net asset value performance. At the year end, £72m of the facility was deployed and the gearing ratio, which is net debt to Shareholders’ Funds, was 5.1%.

Beyond the potential to enhance returns, the credit facility provides flexibility to conduct buy-backs and allows the Managers to react nimbly to new opportunities without disturbing existing investments. In what can often be a volatile and relatively illiquid asset class, these are important benefits and the Managers took advantage of them over the past twelve months.

Share buy-back

The Board believes that buy-backs provide an increase in liquidity at the margin for those Shareholders looking to crystallise their investment and, at the same time, deliver an economic uplift for those Shareholders wishing to remain invested in the Company.

In the year to 31 December 2023, 930,000 shares were bought back and cancelled. The total value of these repurchases was £11.6m, on an average discount of 13.3%. Since 2008, ASCoT’s share buy-backs have totalled £158m and added £24m of value to shareholders.

The Company seeks authority to buy back up to 14.99% of its Ordinary Shares at the Annual General Meeting. The authority was renewed in March 2023 and the Board will seek to renew the authority at the Annual General Meeting on 5 March 2024.

Stewardship

The Board is responsible for the effective stewardship of the Company’s affairs and oversees the activities of the Managers in relation to Environmental, Social and Governance (ESG) matters. Pages 14 to 16 of the Annual Report cover the Board’s oversight and activities in 2023. They also address the Managers’ ESG policies and practices, along with their voting approach and activity during the year. The Board endorses the Managers’ stewardship policy, which is set out in their submission as a signatory to the UK Stewardship Code. This, together with examples relating to voting and engagement with investee companies, can be found in the “About Aberforth” section of the Managers’ website at www.aberforth.co.uk.

Board Composition

The Board regularly reviews its composition and structure in line with corporate governance requirements. As I previewed last year, as part of the Board’s succession planning Julia Le Blan retired from the Board during the year and Patricia Dimond took over as chair of the Audit Committee. Furthermore, Jaz Bains became a member of the Audit Committee.

In addition, the Board has decided, given its relatively small size, that Martin Warner will be appointed to the Audit Committee from 1 February 2024 having previously attended by invitation. In the past, the Audit Committee chair has performed the role of Senior Independent Director (SID) as and when needed. The Board has decided to formalise this with the appointment of Patricia Dimond as SID from 1 February 2024.

Annual General Meeting (“AGM”)

The AGM will be held at 14 Melville Street, Edinburgh EH3 7NS at 10.30 am on 5 March 2024. Details of the resolutions to be considered by Shareholders are set out in the Notice of the Meeting on page 62 of the Annual Report. Shareholders are encouraged to submit their vote by proxy in advance of the meeting. In accordance with normal practice, the results of the AGM will be issued in a regulatory news announcement and posted on Aberforth’s website. An update on performance and the portfolio will also be available on the website following the meeting.

Conclusion

It promises to be a fascinating year on both the economic and political fronts. The outcome of the Presidential Election in the US will set the tone for global financial markets over the medium term, while the UK’s General Election will affect the trading environment for many smaller companies. At this stage, the UK election would appear to carry less risk. A smooth change of government could help restore confidence in UK politics and erode the political discount that has afflicted UK stockmarket valuations since the EU referendum.

At the same time, there is good reason to reappraise the UK’s economic performance. It is now clear that the economy fared less badly during the pandemic than initially feared. Furthermore, recent inflation data indicate that the UK is not an outlier and that the Bank of England will have scope to reduce interest rates in coming quarters. Whether these cuts will be enough to mitigate the impact of previous monetary tightening remains to be seen. The risk of a recession lingers, though it may be mitigated as growth in wages and benefits moves above the rate of inflation.

A downturn would be unfortunate for the country – recessions bring financial stress and hardship to households and companies alike. However, from ASCoT’s perspective, the question of whether we experience recession now feels academic. As the Managers’ Report makes clear, a downturn is baked into the valuations of ASCoT’s investee companies. So, in practical terms, the more interesting question is what will allow the stockmarket to move on and to anticipate recovery. Though there will be a myriad of complicating factors, the straightforward response is the reality of interest rate cuts.

In the meantime, my fellow directors and I are excited by ASCoT’s prospects. In a constantly changing industry, the Managers’ value investment philosophy and their consistent investment process are important differentiators. They have underpinned the Company’s 33 year record and their relevance today is undiminished. We have also been encouraged by the additional insights shared in the Managers’ Report into their engagement approach. Through our discussions with them over the years, it is clear that engagement has made an important contribution to ASCoT’s investment returns. Insights of this sort are a further support of the Board’s ambition to keep ASCoT’s dividend growing in real terms. This can reward Shareholders for our patience as we await a broader appreciation of small UK quoted companies and UK equities in general. When that reappraisal happens, the very attractive valuations of ASCoT’s portfolio bode well for a period of strong investment returns.

Finally, my fellow Directors and I are always keen to receive the views of Shareholders – please contact me at my e-mail

address, which is noted below.

Richard Davidson

Chairman

31 January 2024

[email protected]

MANAGERS’ REPORT

Introduction

ASCoT’s net asset value total return in the twelve months to 31 December 2023 was +8.2%. Over the same period, the NSCI (XIC) – ASCoT’s benchmark – rose by 10.1%. The FTSE All-Share, which is representative of larger UK companies, was up by 7.9%.

Investment Background

Geopolitical risk was already elevated at the start of 2023 as the war in Ukraine continued. It rose further towards the end of the year with Hamas’s attack on Israel. However, financial markets were dominated by one issue – inflation and its implications for monetary policy, especially US monetary policy. Persistent inflation had driven the Federal Reserve to raise interest rates by a cumulative 525 basis points in the sixteen months to July 2023. This brought to an end the era of very low borrowing costs that followed the global financial crisis of 2007 and 2008. Understandably, markets have struggled with this new reality and have been eager for indications that inflationary pressure might be relenting.

The ebb and flow of sentiment through the year can be gauged from the US ten year government bond yield. This started 2023 at 3.8% and surged to 5.0% in August, which was its highest level since 2007. As inflation data improved and markets started to anticipate lower interest rates, the yield dropped to 3.9% by the year end, a move that was echoed by the strong performance of equity indices over the last two months of the year.

The UK and much of Europe are also facing higher borrowing costs. These contributed to lacklustre economic growth in 2023, compounding the effects of high energy costs and waning momentum from the pandemic recovery. Recession threatens several European economies, including the UK’s, while China’s reopening has so far proved rather tepid. The brighter spots in terms of economic activity are the US, which is benefiting from government spending through the Inflation Reduction Act and other programmes, and some emerging economies, which are proving more resilient than in past phases of US monetary tightening.

An overall weaker economic backdrop has complicated trading for companies. Results for 2023 will be reported in the first half of 2024 and are likely to show that profits declined in the UK and in Europe. Even the US stockmarket is expected to experience next to no profit growth, notwithstanding its “magnificent seven” technology leviathans. There are several reasons for this. First, higher interest rates and the other macro-economic uncertainties have put pressure on revenues. Second, it is proving more difficult to raise selling prices as the rate of inflation reduces, but labour costs are continuing to rise. These are harder to pass through to customers, which squeezes profit margins. Third, the cost of borrowing is rising as debt terms are renegotiated in today’s environment of higher interest rates.

Turning specifically to small UK quoted companies, the Managers expect a double digit percentage decline in profits for 2023, with falls for nearly half of the profitable companies that they track closely. Unsurprisingly, those companies operating close to the housing market have been most affected, but it has been notable that overseas facing companies also experienced more challenging trading conditions in the second half of 2023. The effect of this slowdown on profits might be close to half of the impact typically experienced in a full economic recession. Strong balance sheets and battle-hardened boards of directors offer mitigation, but what is important for ASCoT is how much of this is already embedded in the stockmarket’s valuations of the companies. This is considered in detail in the Valuations section of this report.

Analysis of performance and portfolio characteristics

Over the twelve months to 31 December 2023, ASCoT’s net asset value total return was +8.2% and the NSCI (XIC)’s was +10.1%. An analysis of the difference between the two numbers is shown in the table below. The most important influence on ASCoT’s return was the performance of the companies that make up its portfolio of investments.

The next table sets out a series of characteristics of both the portfolio and the NSCI (XIC). The paragraphs that follow provide context and explanation for these characteristics and for ASCoT’s performance in 2023.

*”Smaller small” companies are members of the NSCI (XIC) that are not also members of the FTSE 250

Style & size

Since the pandemic recovery started in late 2020, inflation has caused interest rates and bond yields to rise. These conditions have favoured the value investment style. The London Business School analyses style effects within the NSCI (XIC) using price-to-book ratios to differentiate between value and growth stocks. They calculate that the total return of the index’s value cohort exceeded that of its growth cohort in 2021, 2022 and 2023. A caveat to this positive style backdrop for value is the very strong share price performance in 2023 of the large US technology companies collectively known as the “magnificent seven”. This suggests a more favourable environment for growth stocks, which would be consistent with the stockmarket’s current optimism about an end to the cycle of higher interest rates. Nevertheless, the positive backdrop for the value investment style has benefited ASCoT’s returns over recent years.

Turning to size, the NSCI (XIC) has a significant overlap with the FTSE 250 index: 72% of its value is represented by mid cap stocks. The portfolio’s weighting in these is much lower at 39%, with the majority made up of holdings in the more attractively valued “smaller small” companies. The share price performances of the “larger small” and “smaller small” companies were similar through 2023 as a whole. However, the stockmarket rally at the end of the year was led by the mid caps, which out-performed their smaller peers by 5% in just over two months. This hampered ASCoT’s performance as the year drew to a close. In periods of rapid share price moves, both upwards and downwards, it is common for the “larger small” companies to lead the way and for the “smaller smalls” to catch up in due course.

Balance sheets

The table below shows the balance sheet profile of the portfolio and of the Tracked Universe, which is a subset of the NSCI (XIC). It comprises 234 companies, which the Managers follow closely and which together represent 98% by value of the total NSCI (XIC) index.

Small companies’ balance sheets have not been so strong since around 2014. Back then, a phase of balance sheet repair was a reaction to 2009’s recession. Today, balance sheets are already in a robust state. This should limit the risk to dividends and the requirement for equity issuance in the event of an economic downturn. Strong balance sheets also help to mitigate refinancing risk, as companies’ borrowing costs rise amid the current environment of higher interest rates.

The balance sheet profiles of the portfolio and the Tracked Universe are similar, with high exposures to companies with net cash or modest degrees of leverage. The opportunity for ASCoT to invest in these companies comes from the stockmarket’s aversion to the UK and to its smaller companies in particular. Their fundamental attributes are being ignored and pricing inefficiencies abound.

Another fundamental change being widely overlooked is the improvement in the funding position of defined benefit pension schemes. For two decades, UK companies have deployed large amounts of their free cash flow to reduce pension deficits. A silver lining to the cloud of higher interest rates has been the narrowing of these deficits. Many pension scheme trustees are now able to contemplate de-risking, which relieves the sponsoring companies of the requirement to make top-up payments. The boost to free cash flow is often significant and several of ASCoT’s holdings benefited in this way through 2023.

Income

The portfolio’s income performance in 2023 was good, with income earned by ASCoT reaching its highest ever level. Seven special dividends chipped in, but the main influence was a further recovery in profits from the pandemic. Inevitably, that momentum is starting to fade as profits and pay-out ratios approach pre-pandemic levels.

The table above splits ASCoT’s 78 holdings into five categories, which are determined by each company’s most recent dividend action. The most populous category remains the Increased Payers, though there are proportionately fewer than last year. Three companies returned to paying a dividend, having previously been classified as Nil Payers. This transition can provide a significant boost to ASCoT’s income and a further five holdings are presently expected to make the shift from Nil Payer to New / Returner over the next eighteen months.

The historical dividend yield of ASCoT’s holdings at 31 December 2023 was 4.2%, which was 28% higher than the average over ASCoT’s 33 year history. Dividend cover of 3.0x also compared well with the long term average of 2.8x. This feature, along with the portfolio’s strong balance sheets, should support ASCoT’s income experience as corporate profitability is coming under pressure.

Corporate activity

Despite the backdrop of higher interest rates and borrowing costs, M&A continued apace in 2023. The takeovers of twelve NSCI (XIC) constituents were completed in the year. ASCoT had holdings in six of these. The average EV/EBITA multiple at which the deals were executed was 12.4x, while the average premium to the pre-announcement share prices was an unusually high 66%.

Somewhat surprisingly, private equity houses were the bidders in seven of the twelve deals. The Managers had expected the higher cost of borrowing to limit this source of interest. However, the very low valuations accorded to small UK quoted companies by the stockmarket give private equity the opportunity. At these valuations, it would appear that debt is not needed at the outset to make M&A models work. This remarkable situation highlights a risk to ASCoT and other investors in the asset class – in many cases, even a large takeover premium may not bring the valuation to a level that reflects the true worth of the target company.

In such circumstances, the Managers are prepared to vote against under-priced deals and did so in 2023. The best M&A experiences are often those in which boards of directors consult shareholders well in advance. Such consultation reduces the risk of embarrassment, should shareholders find proposed terms unacceptable, and can lead to better outcomes, which may be that the company in question retains its independence. The Managers make it clear to the boards of the investee companies that they should be consulted in such situations and that they are willing to be insiders for extended periods.

ASCoT’s gearing

ASCoT employs gearing tactically to take advantage of periods of stress in financial markets. It is currently geared for the fourth time in its history, having drawn on its borrowing facility amid the pandemic in 2020. Since then, gearing has enhanced ASCoT’s returns, but valuations of smaller companies remain very attractive. As long as the opportunity embedded in these valuations remains, it is appropriate for ASCoT to retain some gearing. At 31 December 2023, the gearing ratio was 5.1%, down from 5.7% at the start of the year. The reduction is influenced by the rise in share prices over the period and by the timing of purchases and sales.

Active share

Active share is a measure of how different a portfolio is from an index. The ratio is calculated as half of the sum of the absolute differences between each stock’s weighting in the index and its weighting in the portfolio. The higher a portfolio’s active share, the higher its chance of performing differently from the index, for better or worse. The Managers target an active share ratio of at least 70% for ASCoT’s portfolio compared with the NSCI (XIC). At 31 December 2023, it stood at 75%.

Value roll and portfolio turnover

The main influence on ASCoT’s portfolio turnover in any period is usually the stockmarket’s appetite for small UK quoted companies. If prices and valuations are rising, the upsides to the Managers’ target prices are likely to be narrowing. All else being equal, this would encourage the rotation of ASCoT’s capital from companies with lower upsides to those with higher upsides. The Managers term this dynamic the “value roll” and it has played an important role in ASCoT’s capital and income returns over the years. It follows that periods of higher portfolio turnover are often associated with strong returns for ASCoT.

In 2023, portfolio turnover, defined as the lower of purchases and sales divided by average portfolio value, was 20%. This is below the long term average of 34%. Notwithstanding ASCoT’s positive return in the year, this suggests that there was less opportunity for “value roll” than usual. This is another symptom of the deep under-valuation of small UK quoted companies – if the stockmarket does not reflect their true value, there is every incentive to maintain the position.

Environmental, social and governance (ESG)

The issues underlying this umbrella term bring both threats and opportunities to individual companies. Additionally, it seems likely that the valuation of the asset class as a whole is affected by the view that small companies are ESG victims. The Managers disagree and believe that the passage of time will show that small companies are coping well with the challenges of ESG. A broader appreciation of this ought to contribute to a re-rating of the asset class in due course, which should benefit ASCoT’s returns.

In 2023, the Managers continued to populate the ESG module within their investment database. This module was launched in 2022 and is intended to provide insights into the portfolio’s ESG profile as the data set is enriched over time. It also allows the Managers to track and prioritise engagement activities. Work in 2023 indicated that smaller companies are coping well with the increasing expectations and regulations associated with ESG. Disclosure continues to improve and action is being taken to address underlying issues. When that is not the case, the Managers engage to understand the reason and seek change where appropriate. Beyond this, they also encourage companies to think about and articulate opportunities arising from environmental and social issues, such as climate change. To this point, several industrial companies in which ASCoT invests manufacture products that generate both financial and emission savings for their customers. Examples are provided in the Stewardship & ESG section of the Managers’ website at www.aberforth.co.uk. Further details of the Managers’ approach to ESG are set out on pages 14 to 16 of the annual report.

Engagement

Since ASCoT’s inception in 1990, an integral part of Aberforth’s investment process has been engagement with the boards of the investee companies. The Managers often take significant stakes in investee companies – up to 25% of issued share capital across Aberforth’s client base. Engagement is therefore a responsibility. Importantly, it is also a means to improve investment outcomes. Aberforth’s approach to engagement is intended to be purposeful, discreet and constructive. It includes regular updates with executive directors and also encompasses meetings with non executives. There is a particular focus on the chair, which is the most important role in the UK’s system of corporate governance. The Managers engage on any topic that affects the value of an investment or the rights of shareholders, with the most common being capital allocation.

The Managers are prepared to be taken inside for extended periods, which indicates their commitment to responsible stewardship and which can be helpful to investee companies. They also expect to be consulted in a timely fashion – the presentation of a fait accompli by the board to shareholders is a risky and unhelpful undertaking. Several of the takeovers in recent years have been presented without due consultation and have led to the Managers engaging to improve the terms for shareholders and/or voting against the deals. The Managers are confident that their purposeful, discreet and constructive engagement has enhanced ASCoT’s returns over time.

Valuations

The chart depicts the historical price earnings ratio (PE) of ASCoT’s portfolio. At 31 December 2023, the PE was 7.9x, which was more than one standard deviation below the 33 year average of 12.1x. History suggests that this only happens during recession – the early 1990s downturn towards the left of the chart, the global financial crisis in the middle and more recently the pandemic recession.

If share prices are unchanged over the next twelve months, it is likely that the historical PE will rise. This would reflect lower reported profits, consistent with the description given in the introduction to this report. Lower profits are clearly not to be welcomed, but they are not inconsistent with good equity returns because the stockmarket focuses on what will happen rather than what has happened. In the early 1990s recession, small company profits declined by 25-30% over three years, while the PE of ASCoT’s portfolio rose from 7x at the end of 1990 to a high of almost 19x at the end of 1993. Investors more than doubled their money in total return terms over that period.

Aside from concern about the near term outlook for corporate profits, three other factors contribute to the particularly attractive levels of valuation currently accorded to ASCoT’s portfolio. These are the prevailing malaise with the UK and its stockmarket, the concern about the liquidity of smaller companies, and the effect of the Managers’ value investment style. The following paragraphs address each of these factors.

• At 31 December 2023, the FTSE All-Share’s PE was 35% lower than Panmure Gordon’s calculation of the PE for the Rest of the World. Since 1990, the average discount of UK equities has been 16%. Several justifications for today’s larger than usual discount are regularly offered.

First, since the EU referendum in 2016 and with the subsequent succession of Prime Ministers, the UK’s reputation for political stability has been impaired. However, the UK does not have a monopoly in political uncertainty. The UK’s flirtation with populism may prove to be behind it, while elections over the coming years may cast other countries in a relatively unfavourable light.

Second, there is a widespread view that the UK’s economic performance in recent years has been comparatively poor, from Brexit through a proportionately tougher lockdown experience to a more intransigent problem with inflation. However, Brexit’s impact is largely in the past – the companies with which the Managers engage have learned to live with it. Turning to the pandemic, recent revisions by the ONS to its calculation of GDP reveal that the UK’s recovery compares well with other members of the G7. Finally, the gap between the UK’s inflation rate and that of comparable countries is now narrowing to undermine arguments that the UK is the “sick man of Europe”.

Third, there is a concern that the UK stockmarket itself is dysfunctional. Evidence cited includes its lack of technology companies, infrequent and unsuccessful IPOs, low valuations, and outflows from pension and open-ended funds. Some of this reasoning is circular, but the issue has caught the attention of government, for better or worse. Mooted solutions are mandated investment in UK listed companies by pension funds, lower governance standards for UK listings and the dilution of EU inspired regulation on UK capital markets. For the Managers, it is not clear that the UK stockmarket is broken and well-intended legislation is often undermined in due course by the unintended consequences.

• Within the UK market, there is a pronounced valuation discount for size – the lower the market capitalisation, the lower the valuation. Within the NSCI (XIC), the average 2023 EV/EBITA ratio of companies with market capitalisations above £600m (roughly the boundary between the FTSE 250 and the FTSE SmallCap) is 11.0x. For those below the £600m threshold, the “smaller small” companies, the average multiple is 23% lower at 8.4x.

For smaller companies, the general concerns about the UK are compounded by their greater reliance on the domestic economy. Around 50% of the aggregate revenues of NSCI (XIC)’s constituents are generated within the UK, higher than the 20-25% or so for the entire UK stockmarket. While companies close to the domestic housing market have reported more difficult trading conditions for the past nine months, it is notable that their share prices have often fallen by less than the extent of the downgrade to profit expectations. This is an indication that economic weakness is reflected in valuations, which is a necessary, though not sufficient, condition for recovery.

Against the background of disinvestment from UK equities, there is a heightened sensitivity towards liquidity on the part of many investors. This is likely to have penalised the valuations of the relatively illiquid asset class of smaller companies. However, such an investment stance risks missing the small company premium, which is the historical out-performance of small over large and which has averaged 1.6% per annum over ASCoT’s 33 years. Investors are rewarded for taking on liquidity risk over time and relative illiquidity works both ways. Gaining exposure to the asset class when sentiment turns is not straightforward – as so often in investment, time in the market is more important than timing the market.

• Turning to ASCoT’s portfolio, the 7.9x historical PE at 31 December 2023 was 38% below that of the NSCI (XIC). This compares with an average discount of 12% since 1990.

ASCoT’s portfolio is managed in accordance with the value investment style and so a discount to the overall valuation of smaller companies is to be expected. However, the discount today is unusually wide. Part of this is explained by the better value on offer among the NSCI (XIC)’s “smaller small” companies, to which ASCoT has a relatively high exposure. Another factor is the Managers’ willingness to look through general concern about near term corporate profitability by investing in strong and growing but economically sensitive companies. Unburdened by these distractions, ASCoT’s opportunity set within the investment universe is presently towards its widest in its history.

The following table sets out further detail about the forward valuations of the portfolio, the Tracked Universe and certain subdivisions of the Tracked Universe. The metric displayed is enterprise value to earnings before interest, tax and amortisation (EV/EBITA), which the Managers use most often in valuing companies. The ratios are based on the Managers’ profit forecasts for each company that they track. The bullet points following the table summarise its main messages.

• The higher multiples for 2023 compared with 2022 are consistent with earlier comments about lower company profits in 2023. The Managers’ forecasts currently point to a profit recovery in 2024, but the precise timing of a rebound relies on the domestic and overseas economic backdrop.
• The average EV/EBITA multiples of the portfolio are lower than those of the Tracked Universe. This has been a consistent feature over ASCoT’s history and is consistent with the Managers’ value investment style.
• The portfolio’s 8.1x EV/EBITA ratio for 2023 is considerably lower than the average multiple of 12.4x at which the year’s completed M&A deals were struck.
• Each year, the Managers identify a cohort of growth stocks within the NSCI (XIC). These stocks are on much higher multiples than both the portfolio and the rest of the Tracked Universe.

Outlook and conclusion

The financial markets enter 2024 in much the same way as they did 2023 – focused on US interest rates and hopeful that a turn in the cycle towards looser monetary policy is near at hand. In contrast to twelve months ago, today there is a declining rate of inflation in most economies as energy prices subside and global supply chains improve. A cut in US interest rates in the first quarter of the year is now priced into markets. If this is achieved, the probability rises of a “soft landing” – the Federal Reserve, despite much criticism for having been slow to respond to inflation, may yet be able to loosen monetary policy without first tipping the US economy into recession.

However, some circumspection is necessary. In particular, the US continues its ambitious fiscal programmes, with government spending in the final months of 2023 rising at double digit rates. This contributed to annualised growth in nominal GDP of almost 9% in the third quarter. With full employment and the US electoral cycle to consider, so robust an economic backdrop is not one normally associated with quiescent inflation. Therefore, financial markets may continue to be troubled by inflation and US monetary policy over the next twelve months. Moreover, it would be bold to assume that the recent easing of price pressures means that inflation will return to the very low single digit rates of the pre-pandemic period.

US interest rates are likely to dictate the near term mood of global financial markets, the UK’s included. But equity returns over time are heavily influenced by starting valuations, which stockmarkets can take to extreme levels in their fits of despondency and elation. As the previous section of this report described, the low valuations ascribed to UK equities, smaller companies and, in particular, ASCoT’s portfolio bode well for returns over the medium term. It is not straightforward to identify what will change to shine the spotlight on the value on offer in the UK – were it easy, after all, valuations would not now be so attractive. However, while acknowledging the present debate about the relevance of the UK stockmarket, the Managers retain confidence in its ability to reflect fairer valuations in due course. Awaiting a general re-rating of the UK listed companies, ASCoT is well placed to prosper in the meantime.

• With the outlook for inflation and interest rates more nuanced than in the pre-pandemic period, there is reason to believe that the value investment style can help ASCoT’s returns, as it has over the past three years. The Managers’ commitment to value investment sets ASCoT apart from most other funds in the small company arena.
• ASCoT’s portfolio is skewed towards resilient companies with strong balance sheets and experienced boards of directors who proved themselves amid the challenges of the pandemic. If, as seems likely, this is a period of more difficult trading conditions, it is plausible that the investee companies emerge in a stronger competitive position as they have in previous cycles.
• The investee companies’ resilience should support their dividends and by extension the income ASCoT earns. ASCoT also benefits from its revenue reserves, which have been carefully nurtured to allow the dividend record to continue when the macro-economic environment deteriorates. These characteristics support the Board’s ambition to grow ASCoT’s dividends at a rate above that of inflation.
• In the absence of a widespread revaluation of companies listed on the UK stockmarket, takeover activity is likely to continue. This is an obvious means through which the value gaps that characterise ASCoT’s portfolio can be realised. Takeovers are appropriate as long as the offer terms reflect the target company’s true value and are not anchored by the prevailing stockmarket price.
• Both in M&A situations and more broadly, the Managers will continue to engage with the boards of investee companies in order to improve outcomes for investors. Discreet, purposeful and constructive engagement is all the more relevant today when valuations are so low and directors are frustrated by what the stockmarket appears to be saying about the companies that they run.

These factors contribute to the strength and relevance of ASCoT’s investment proposition, which the Managers believe can produce good returns for investors as we wait for a re-rating of the UK equity market and its smaller companies. When that re-rating does arrive, ASCoT’s attractively valued portfolio and tactical gearing mean that it is well-placed to take full advantage.

Aberforth Partners

Managers

31 January 2024

DIRECTORS’ RESPONSIBILITY STATEMENT

Each of the Directors confirms to the best of their knowledge that:

(a) the financial statements, which have been prepared in accordance with applicable accounting standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company;

(b) the Strategic Report includes a fair review of the development and performance of the business and the position of the Company, together with a description of the principal risks and uncertainties that it faces; and

(c) the Annual Report, taken as a whole, is fair, balanced and understandable and provides information necessary for Shareholders to assess the Company’s position, performance, business model and strategy.

On behalf of the Board

Richard Davidson

Chairman

31 January 2024

PRINCIPAL RISKS

The Board carefully considers the risks faced by the Company and seeks to manage these risks through continual review, evaluation, mitigating controls and action as necessary. A risk matrix for the Company is maintained. It groups risks into the following categories: portfolio management; investor relations; regulatory and legal; and financial reporting. Further information regarding the Board’s governance oversight of risk and the context for risks can be found in the Corporate Governance Report on page 35 of the Annual Report. The Audit Committee Report (pages 36 to 38 of the Annual Report) details the committee's review process, matters considered, and actions taken on internal controls and risks during the year. The Audit Committee completed a significant review and reassessment of the risk register in the year. This included assessing the risks and supporting documentation, and enhancing the detailed risk register reporting. The Company outsources all the main operational activities to recognised, well-established firms and the Board receives internal control reports from these firms, where available, to review the effectiveness of their control frameworks.

Emerging risks are those that are still evolving, and are not fully understood, but that could have a future impact on the Company. The Board regularly reviews them and, during the year, it added to the risk matrix the potential risks arising from reduced market demand for UK listed companies and also the risks arising in the investment company sector from reduced investor demand. The Board monitors these risks and how the Managers integrate such risks into their investment decision making.

Principal risks are those risks in the matrix that have the highest ratings based on likelihood and impact. They tend to be relatively consistent from year to year given the nature of the Company and its business. The principal risks faced by the Company, together with the approach taken by the Board towards them, are summarised below. To indicate the extent to which the principal risks change during the year and the level of monitoring required, each principal risk has been categorised as either dynamic risk, requiring detailed monitoring as it can change regularly, or stable risk.

Going Concern

The Audit Committee has undertaken and documented an assessment of whether the Company is a going concern for the period of at least 12 months from the date of approval of the financial statements. The Committee reported the results of its assessment to the Board. The Company’s business activities, capital structure and borrowing facilities, together with the factors likely to affect its development and performance, are set out in the Strategic Report contained in the Annual Report. In addition, the Annual Report includes the Company’s objectives, policies and processes for managing its capital and financial risk, along with details of its financial instruments and its exposures to credit risk and liquidity risk. The Company’s assets comprise mainly readily realisable equity securities and funding flexibility can typically be achieved through the use of the borrowing facilities, which are described in notes 12 and 13 to the financial statements in the Annual Report. The Company has adequate financial resources to enable it to meet its day-to-day working capital requirements. In summary and taking into consideration all available information, the Directors have concluded it is appropriate to continue to prepare the financial statements on a going concern basis.

The Income Statement, Balance Sheet, Reconciliation of Movements in Shareholders’ Funds and summary Cash Flow Statement are set out below.

INCOME STATEMENT

For the year ended 31 December 2023

(audited)

The Board declared on 31 January 2024 a final dividend of 28.55p per Ordinary Share and a special dividend of 9.00p per Ordinary Share. The Board declared on 26 July 2023 an interim dividend of 12.95p per Ordinary Share.

The total column of this statement is the profit and loss account of the Company. All revenue and capital items in the above statement derive from continuing operations. No operations were acquired or discontinued in the year. A Statement of Comprehensive Income is not required as all gains and losses of the Company have been reflected in the above statement.             

RECONCILIATION OF MOVEMENTS IN SHAREHOLDERS’ FUNDS

For the year ended 31 December 2023

(audited)

For the year ended 31 December 2022

(audited)

BALANCE SHEET

As at 31 December 2023

(audited)

CASH FLOW STATEMENT

For the year ended 31 December 2023

(audited)

SUMMARY NOTES TO THE FINANCIAL STATEMENTS

1. SIGNIFICANT ACCOUNTING POLICIES        

The financial statements have been presented under Financial Reporting Standard 102 ("FRS 102") and under the AIC’s Statement of Recommended Practice “Financial Statements of Investment Trust Companies and Venture Capital Trusts” ("SORP"). The financial statements have been prepared on a going concern basis under the historical cost convention, modified to include the revaluation of the Company’s investments as described below. The Directors' assessment of the basis of going concern is described above. The functional and presentation currency is pounds sterling, which is the currency of the environment in which the Company operates. The Board confirms that no critical accounting judgements or significant sources of estimation uncertainty have been applied to the financial statements and therefore there is not a significant risk of a material adjustment to the carrying amounts of assets and liabilities within the next financial year.

2. INVESTMENT MANAGEMENT FEE AND BANK BORROWINGS

The Managers, Aberforth Partners LLP, receive an annual management fee, payable quarterly in advance, equal to 0.75% of net assets up to £1 billion, and 0.65% thereafter.

The investment management fee and finance costs of bank borrowings have been allocated 62.5% to capital reserve and 37.5% to revenue reserve, in line with the Board’s expected long term split of returns, in the form of capital gains and income respectively, from the investment portfolio of the Company.

3. DIVIDENDS         

The final dividend of 28.55p (2022: 26.95p) and special dividend of 9.00p (2022: 8.30p) for the year ended 31 December 2023 will be paid, subject to shareholder approval, on 8 March 2024. The final and special dividends for 2023 and 2022 have not been included as liabilities in the financial statements.

4. RETURNS PER ORDINARY SHARE                                                                                                            

There are no dilutive or potentially dilutive shares in issue.

5. INVESTMENTS AT FAIR VALUE

In accordance with FRS 102 fair value measurements have been classified using the fair value hierarchy:

Level 1 - using unadjusted quoted prices for identical instruments in an active market;

Level 2 - using inputs, other than quoted prices included within Level 1, that are directly or indirectly observable (based on market data); and

Level 3 - using inputs that are unobservable (for which market data is unavailable).

Investments held as fair value through profit or loss

6. NET ASSET VALUE PER SHARE         

The Net Asset Value per share and the net assets attributable to the Ordinary Shares at the year end are calculated in accordance with their entitlements in the Articles of Association and were as follows.                                         

7. SHARE CAPITAL

During the year, the Company bought back and cancelled 930,000 shares (2022: 2,603,661) at a total cost of £11,641,000 (2022: £33,296,000). During the period 1 January to 31 January 2024, 30,000 shares have been bought back for cancellation.

8. RELATED PARTY TRANSACTIONS

The Directors have been identified as related parties and their fees and shareholdings are detailed in the Directors’ Remuneration Report on pages 40 and 41 of the Annual Report. During the year no Director was interested in any contract or other matter requiring disclosure under section 412 of the Companies Act 2006.

9. Alternative Performance Measures

Alternative Performance Measures ("APMs") are measures that are not defined by FRS 102 and FRS 104. The Company believes that APMs, referred to as ‘Key Performance Indicators’ on page 5 of the Annual Report, provide Shareholders with important information on the Company and are appropriate for an investment trust company. These APMs are also a component of reporting to the Board. A glossary of APMs can be found in the 2023 Annual Report.

10. FURTHER INFORMATION

The foregoing do not constitute statutory accounts (as defined in section 434(3) of the Companies Act 2006) of the Company. The statutory accounts for the year ended 31 December 2022 which contained an unqualified Report of the Auditors, have been lodged with the Registrar of Companies and did not contain a statement required under section 498(2) or (3) of the Companies Act 2006.

Certain statements in this announcement are forward looking statements.  By their nature, forward looking statements involve a number of risks, uncertainties or assumptions that could cause actual results or events to differ materially from those expressed or implied by those statements.  Forward looking statements regarding past trends or activities should not be taken as representation that such trends or activities will continue in the future.  Accordingly, undue reliance should not be placed on forward looking statements.

The Annual Report is expected to be posted to shareholders by 8 February 2024.  Members of the public may obtain copies from Aberforth Partners LLP, 14 Melville Street, Edinburgh EH3 7NS or from its website: www.aberforth.co.uk.

CONTACT: Euan Macdonald or Jeremy Hall, Aberforth Partners LLP, 0131 220 0733

ANNOUNCEMENT ENDS